European growth stutters along as fear of deflation exerts pressure on the ECB to loosen monetary policy further.

January began with a raft of optimistic news stories. For example, the government deficit/GDP ratio for the entire Euroarea (EA17) fell from 3.3% to 3.1% from the second to the third quarter of 2013. In a similar vein, the US led recovery was solidifying, and 2014 was roundly expected to be another strong year for financial markets.

Yet, other data releases were less encouraging. Retail trade (EA17) was down by 1% in the year to December; industrial producer prices were down 0.8% in the same period; and the unemployment number for December was unchanged from October at 12%. Furthermore, Eurostat forecast that for the year to January 2014, annual inflation will have fallen to 0.7% (from 0.8% for the year to December).

The spectre of deflation is the greatest fear of policymakers, and a large amount of policymaker credibility is now invested in the pledge to repel the threat of falling prices. If such efforts fail, confidence in centralised monetary policy will be shaken, and national EA17 governments will start pulling in different directions. Renewed tensions will follow. For example, the German authorities’ doubts on the legitimacy of Outright Monetary Transactions (buying sovereign debt of embattled countries) have not abated. Germany’s constitutional court has refused to rule on the matter, and passed the dossier to the European Court of Justice. That has given the EU/ECB authorities breathing space, but it has also ensured that OMTs can hardly be deployed before the court has reached a decision.

Summary

The dominant central banking news centred on further tapering announced by the US Federal Reserve and its context. How solid is the much vaunted US economy’s return to growth?

The market’s smooth digestion of the mid December announcement of the start of tapering encouraged the Federal Reserve to announce in January a second $10 billion reduction to the asset purchase programme.

The official view remains that the US recovery is at “escape velocity”. However, the data cited in support of this — falling unemployment, and GDP growth of over 3% per annum – are not very persuasive. As for GDP, the quality of growth has been poor. Most was not due to business investment or household income, but rather to inventories. This is clear from the data on ’Real Final Sales of Domestic Product’ data (in other words GDP less inventories), published by the Federal Reserve Bank of St Louis. Year on year, the US grew by less than 2% in 2013, which implies that most of the 2013 pick up in the US was an unsustainable inventory build-up. The early February news of a sharp fall in factory orders has awoken other commentators to this concern.

Furthermore, the workforce participation rate is at an all time low, as the January official unemployment rate fell from 7% to 6.7%, and the civilian ‘labour force’ fell from 155.3 (million) to 154.9. The labour participation rate is now 62.8%: no lower level has been seen since the trough of the 1978 depression.

Not only commentators, but also the UK’s central bank chief has echoed concerns that similar doubts underlie the UK’s recovery story. On Feb 12th, he abandoned the link between interest rate setting and unemployment, and stated that the UK’s recovery is “neither balanced nor sustainable”.

The new Leverage Ratio Regime: our confidence in the expertise of global rule makers is not rising.

The Basel Committee on Banking Supervision has for five years robustly defended its primary regulatory framework — the capital adequacy rules — in the face of manifest evidence of their weakness. Banks, the Committee argued, should have more capital, certain arbitrage loopholes (such as the parking of assets in off balance sheet companies) should be closed, and risk models need to be tightened.

As the years passed, there has been growing support for the views of certain central bankers that the capital adequacy rules simply do not work. In polite parlance, they are “too complex”. These officials called for a new rule that measures simple leverage. In January, the new Leverage Ratio Framework was published.

Although many media outlets focussed on the differences between the consultation version of the Framework and the final text, few seemed to notice that the January publication opened with an admission that the capital adequacy rule regime had completely failed. The Committee’s stated justification for the new Leverage Ratio framework was as follows:

"An underlying cause of the global financial crisis was the build- up of excessive on -and off – balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while apparently maintaining strong risk -based capital ratios."

This admission, that a bank can look great under the capital adequacy rules but in fact be hopelessly overleveraged, should not be taken lightly, and therefore the January formulation of the Leverage rules is of exceptional importance. Should we now have scant faith in the Committee, or have they learned their lesson and produced a workable coherent new framework?

Mainstream media presented the differences between the final version and the June 2013 consultation as a win for the banking lobby. There are five changes of significance:

a) Banks need not double count securities received as collateral in the context of securities financing transactions (the borrowing and lending of securities).
b) Banks commit themselves to lending and underwriting. The prior proposal was that the full amount of the commitment should be added to the exposure measure. In January, a series of weights was announced depending on the length and nature of the commitment.
c) Cash collateral received in the context of derivatives exposures may be used to reduce the exposure measure.
d) Banks sometimes act as agents for their clients who centrally clear derivatives. In this context, the January amendments eliminate potential double counting.
e) The exposure regarding credit derivatives should be calculated as if they were loans or bonds. However, according to the January amendments, the exposure may be reduced by the purchase of an offsetting credit derivative.

All in all, these ‘concessions’ should not really be presented as a significant win for banks. Points a, c and d are essentially corrections of previously poorly drafted rules. Point b is an attempt to distinguish between trade finance instruments such as standby letters of credit (desirable) and liquidity lines supporting off balance sheet vehicles (less desirable). Put differently, most of the amendments appear to be a matter of common sense.

However, the Committee’s main missed opportunity concerns the treatment of credit derivatives. According to the Leverage Ratio provisions, an offsetting hedge is now considered equivalent to a form of insurance, and it deletes the exposure. Yet, the purchase of offsetting protection does not eliminate risk, since the correlation between the probability of default of the insurer and the default of the underlying reference assets is high. As recent history confirms, there was a perfect correlation between the default risk of AIG (the insurer) and of the subprime mortgage loans (the insured derivatives).

A further concern, as noted in last month’s newsletter, is that rehypothecation and other practices of so-called ‘collateral transformation’ have not been sufficiently understood or addressed, and will almost certainly be a source of financial system fragility in the future.